Page 127 - Microsoft Word - 00 P1 IW Prelims.docx

Project management I: The business case

7.4 Internal rate of return (IRR)

The Internal Rate of Return (IRR) is the rate of return at which the
project has an NPV of zero.

 If the IRR is greater than the cost of capital, the project should be
accepted.

Calculate two NPVs for the project at two different costs of capital.

NL
IRR = L + × (H – L)
NL – NH

Where L = Lower rate of interest

H = Higher rate of interest
NL = NPV at the lower rate of interest

NH = NPV at higher rate of interest

NPV vs IRR:

The advantage of NPV is that it tells us the absolute increase in
shareholder wealth as a result of accepting the project, at the current
cost of capital. The IRR simply tells us how far the cost of capital could
increase before the project would not be worth accepting.

Suitability This is best for long projects with an unknown costs of capital.

121